The case for Fiscal Councils

Simon Wren-Lewis
-
22 April 2013

Austerity in the midst of a recession when monetary policy has lost much of its power is macroeconomic illiteracy, but with such focus on budget deficits opposition to austerity is seen as irresponsible. Fiscal councils may be one way to bridge the gap between what is economically sensible and what is politically possible

Austerity in the midst of a recession when monetary policy has lost much of its power is macroeconomic illiteracy. While the adoption of austerity measures by right wing governments can be explained in terms of hidden motives, it is less understandable why opposition to austerity on the mainstream centre-left is often absent or muted. One possible reason is deficit bias: the tendency by governments of every political complexion to allow government debt to rise in the longer term. While governments have been able to ‘get away with’ this bias in the past, this is no longer possible in an environment where some countries are facing financing crises so that the political focus is on the budget deficit. As a result, any politician that advocates additional borrowing in the current conjuncture is seen as irresponsible.

From a macroeconomic point of view this situation is disastrous, as the current recessions in the euro area and the UK show. So how do we bridge the gap between what is economically sensible and what is politically possible? One possible way forward is to strengthen the role of independent fiscal institutions – sometimes called fiscal councils. Fiscal councils can encourage a more rational approach to macroeconomic fiscal policy.

1. Countercyclical fiscal policy is important in two particular situations
The first is for individual countries in a monetary union, which do not have their own monetary policy. The second is where monetary policy has become ineffective because of a liquidity trap: interest rates have hit the zero lower bound. When these situations do not apply, then there are good reasons for leaving short run macroeconomic stabilisation in the hands of monetary policy.

2. Using fiscal policy in a countercyclical manner
The importance of using fiscal policy in a countercyclical manner within a monetary union was demonstrated by what happened to the eurozone periphery in the years before the financial crisis. For a number of reasons these countries experienced unsustainable economic booms, leading to reckless behaviour by financial institutions and a growing deterioration in competitiveness. These booms should have been aggressively counteracted by very tight fiscal policy, but this did not happen because the Stability and Growth Pact focused on deficits rather than overall macroeconomic conditions.

3. In a liquidity trap, conventional monetary policy loses its power and predictability
Experience in the US and UK shows that unconventional monetary policy (mainly Quantitative Easing), while useful, is far from a complete substitute. As a result, it is necessary to use expansionary fiscal policies to do what monetary policy can no longer do, which is bring recessions to an end. Pursuing pro-cyclical fiscal policy (‘austerity’) in this situation will deepen the recession and delay any recovery.
4. These are not controversial propositions
They are what economic students are taught at the undergraduate and graduate level in nearly all universities. Of course economics is a discipline where you will always be able to find notable economists who take a contrary view, but in this case they are in a small minority. Predictions of ‘expansionary austerity’ have proved hopelessly wrong.

5. Deficit bias remains a serious long run problem
In the 30 years before the financial crisis, government debt in the OECD almost doubled as a share of GDP, and there was no macroeconomic justification for this trend. Higher government debt has clear long term costs: it can discourage private investment, it increases the need for distortionary taxation, and it redistributes income away from future generations.

6. The macroeconomic implications are clear
Government debt should be reduced in good times, but not during a liquidity trap recession. Within a currency union, government debt should also be reduced in good times (there should be large government surpluses), but not in bad times.

7. Unfortunately political incentives produce precisely the opposite pattern
In good times, few pay much attention to budget deficits (in part because they are small as a direct result of the good times), and so politicians who try to cut spending or raise taxes during those periods risk losing popularity. In contrast, in bad times the focus is on rising budget deficits (partly because they tend to rise naturally in a downturn), particularly if some countries are having financing problems because they have borrowed in a currency they cannot print. In these times, arguments that borrowing should increase appear irresponsible.

8. In situations where politics produces perverse economic outcomes, there is a clear case for some form of delegation
This has been well understood in the case of monetary policy, which accounts for the growing movement towards independent central banks. Delegation in the case of fiscal policy is less easy, because detailed fiscal decisions (about the tax and spending mix) should clearly remain under democratic control. However in the last decade many countries have established independent ‘fiscal councils’ that can provide information and advice on aggregate fiscal policy.

9. Fiscal councils can complement fiscal rules
Most fiscal councils operate alongside fiscal rules. Fiscal rules on their own tend to be ineffective, because they are either too simple to allow for important special cases like liquidity traps, or they are sufficiently complicated that they can be circumvented by politicians, either consciously or through over optimism. Fiscal councils can sanction deviations from simple rules when these special cases apply, and they can be a check on government manipulation or over optimism.

10. Fiscal councils can help good politicians do what they would like to do
They can give credibility to governments that recognise the importance of countercyclical fiscal policy when monetary policy is unable to stabilise the economy. They can help expose political opponents who promise tax cuts or additional spending in good times that will in effect be paid for by future generations. In the current context, they can help expose the damage done by untimely austerity.

Simon Wren-Lewis is professor of economics, and a fellow of Merton College, Oxford University

Comments

policy785

23 April 2013 11:18

Letting countries with lower productivity rates devalue their currency would be the easiest and most straightforward solution to the current Eurozone crisis, politically and economically. Progressives should support the simple and straightforward, especially in times of social crisis, rather than making things even more complex and technocratic.

Add comment

Name

Enter the code shown:

The Policy Network Observatory promotes critical debate and reflection on progressive politics. It is centre-left orientated but determinedly challenges social democracy. It is pro-European but restlessly questions EU institutions and practices.